Back in November 2016, the BIS picked up on a topic we have often discussed over the years, namely the critical role that dollar abundance (or shortage) plays in defining market stress, and going one step further, published a research report which made the striking claim that while the VIX was now dead as an indicator of market risk, it had been replaced with the value of the dollar. This is what the Bank of International Settlement said then:

Just as the VIX index was a good summary measure of the price of balance sheet before the crisis, so the dollar has become a good measure of the price of balance sheet after the crisis. The mantle of the barometer of risk appetite and leverage has slipped from the VIX, and has passed to the dollar.

What explains the dollar’s role as the summary measure of the appetite for leverage? In a nutshell… there is a tight “triangular” relationship between (1) the dollar, (2) cross-border bank capital flows in dollars and (3) the deviation from CIP. The key to understanding this relationship is that dollar cross-border capital flows closely track the leverage decisions of global banks. The triangular relationship says volumes about the role of the US dollar in the global banking system, and ultimately how the monetary policy backdrop determines global financial conditions.

Fast forward to this June, when the head of the Reserve Bank of India, Urjit Patel, made a solemn appeal to the Fed: stop shrinking your balance sheet because in combination with the soaring US budget deficit (which requires a surge in new Treasury issuance), you are draining precious USD-liquidity out of the market.

This was the first time this cycle that a prominent foreign central banker accused the Fed of stirring trouble for emerging markets, with its ongoing tightening:

Global spillovers did not manifest themselves until October of last year. But they have been playing out vividly since the Fed started shrinking its balance sheet. This is because the Fed has not adjusted to, or even explicitly recognised, the previously unexpected rise in US government debt issuance. It must now do so.

Patel’s advice? Immediately taper the tapering, or rather, the Fed should “recalibrate its normalisation plan, adjusting for the impact of the deficit. A rough rule of thumb would be to reduce the pace of its balance-sheet contraction by enough to damp significantly, if not fully offset, the shortage of dollar liquidity caused by higher US government borrowing.”

Patel’s punchline: if left unchecked, the EM turmoil “might hurt the US economy as well. Circumstances have changed. So should Fed policy. It would still reach the same destination, but with less turmoil along the way.”

Two months later, the turmoil among emerging markets raging, with the currencies of Turkey, Argentina, Brazil, Russia and even China sliding against the dollar. So far the only part of his prediction that has not manifested, is the contagion from EMs to the US economy.

But that may be only a matter of time, especially if the Turkish crisis spills over into the European banking sector, and from there it crosses the Atlantic.

Meanwhile, focusing on the gloomy reality facing Emerging Markets – and their addition to dollars – is the latest note out of Nedbank’s Neels Heyneke and Mehul Daya, who warn about the troubling fate facing EMs, writing that excess liquidity usually leads to the misallocation of capital, masking any balance sheet constrains. And as this tide of excess liquidity recedes it reveals the misallocation of capital and the mispricing of risk. The two caution that as EMs have benefited the most from this misallocation of credit, yet as the tide of excess liquidity recedes, “EMs will begin to pay the heavy price of this misallocation of credit.” The “spread” between capital misallocation and reality is shown in the chart below.

Where we go full circle with the warnings from both the BIS and Urjit Patel, is that one way to monitor the ebb and flow of excess liquidity is by looking the changes in the value of the USD. As long as the dollar remains the reserve currency and most of the foreign owned debt is denominated in US dollars, for example in the carry trade, the dollar will remain king. Stated simply, “a weaker USD is associated with a stable and healthy global environment whereby the global supply of USD’s is abundant. A stronger USD is usually associated with volatility and a risk-off phase as liquidity contracts” which is basically the point made by the BIS nearly 2 years ago.

As a result of Quantitative Tightening and rising interest rates, since the start of the year the supply of USDs has become scarce amid escalating tit-for-tat trade policies, slowing credit growth in China, and weaker commodity prices. This can be seen clearly in Nedbank’s Global Broad $-Liquidity indicator, shown below.

Going back to Emerging Markets, while until recently investors were eager to attribute sharp drops in various EM nations to idiosyncratic factors, the recent widespread turmoil has become increasingly systemic. Confirming this, Nedbank notes that a number of studies have emerged pointing out that the role of global factors has increased relative to country/corporate specific factors.

This indicates that investors need to place more emphasis on the role of global liquidity (the changing pool of money and credit).

And while investor attention has been captivated by Turkey in recent weeks, Nedbank has some words of advice: “Forget about Turkey’s woes, Asia is the elephant in the room.“

The reason is that South East Asia again stands out as in 1997/8, with a large amount of USD denominated debt outstanding. The only difference is then Asia had fixed exchange rates and now they are floating! Furthermore, Asia’s USD debt, relative to international FX reserves and exports, has risen significantly since 2009. This leaves these nations susceptible to a shortage in USDs (which would manifest itself in a sharply higher dollar price). Meanwhile, the Asian nations that have amassed record amounts of USD debt are also home to the largest technology companies i.e. Tencent (China), Alibab (China), TSNC (Taiwan), Samsung (S.Korea). The tech sector is now 28% of the MSCI EM index.

So between the rally in the US Dollar, dented global growth prospects, slowing Chinese credit growth and escalating political tensions from the US, leaves these nations very exposed to a shortage in USDs. Which is why, in Nedbank’s view, “we believe Asia will be the next source of downside systemic risk for financial markets.“

To be sure, one look at the chart below demonstrates that changing financial conditions have been the major driver of EM asset prices over the last several years. The risk-on phase ended in January and all EM assetss old-off. EM-FX are however now taking the lead and the next few days will indicate whether this will spillover into the other asset classes.

So putting all of the above together, how to determine what happens next? Simple: keep an eye on the dollar… and stick the following EM contagion transmission chart on your wall:

If the dollar keeps rising aggressively at a time when China (which for now has a nice, thick capital controls firewall) is devaluing while other EMs are scrambling to contain capital flight by aggressively hiking rates (such as Argentina’s shocking 45% rate hike yesterday) in the process sending their economies into recession, should the Fed fail to contain the dollar surge, the outcome may well be another Plaza Accord. But not before global markets crash first.